The Future of the Dollar

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It is hard to imagine a happy future for the dollar, and I was going to say that before Robert Fisk published his The Demise of the Dollar, in which he describes secret talks among central bankers and finance ministers of various countries on how to move away from trading oil in dollars.

Is Fisk’s report true? I have already been told once today that the story was a bit too “conspiratorial” to be taken seriously. The expected official denial followed quickly.

But top officials of Saudi Arabia and Russia, speaking on the sidelines of the International Monetary Fund meetings in Istanbul, denied there were such talks. The two countries are the world’s largest and second-largest oil exporters.

Asked by reporters about the newspaper story, Saudi Arabia’s central bank chief Muhammad al-Jasser said: “Absolutely incorrect.” He repeated the same response when asked whether Saudi Arabia was in such talks.

Kuwait’s oil minister and a well-placed source in the Organization of the Petroleum Exporting Countries made similar remarks. Russia’s deputy finance minister Dmitry Pankin said: “We did not discuss this at all.”

Did not discuss trading oil in dollars at all?  The gadfly Robert Fisk just made this story up? I doubt that very much. Why is the fabrication angle implausible? — aside from the hit to his credibility Fisk would take.

Given the continuing deterioration of the dollar, and current U.S. fiscal & monetary policies propelling that deterioration forward, it would be strange if such discussions were not taking place. This is not to say that such a change in how oil is traded is guaranteed to be implemented. There are many obstacles, not least of which is what Eric Janszen calls economic mutually assured destruction in which Asians (and the Persian Gulf States) subsidize U.S. debt to maintain their export markets and the U.S. depends on that “vendor financing” to prop up its economy.

Such a crazy economic arrangement must collapse sooner or later. In October, 2008, Brad Setser provided an example of how things work in The end of Bretton Woods 2?

One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off — though it leaves out the fact that the US also borrows from Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil.

Economist Brad DeLong refers to these arrangements as a financial “balance of terror” (see below).

Surely it is in the best interest of oil consuming & producing countries outside the U.S. to discuss a move away from the dollar. After all, we are talking about a change that is tentatively scheduled to take place within 9 years. A lot can happen in 9 years—or in 9 months or 9 days, as we saw in 2008. From Fisk—

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and…

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years…

The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. “One of the legacies of this crisis may be a recognition of changed economic power relations,” he said in Istanbul ahead of meetings this week of the IMF and World Bank. But it is China’s extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America’s power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states.

Again, what is implausible is that high-level talks are not taking place, not Fisk’s report that they are. The Conventional Wisdom always assumes that what has been is what shall be. T’aint so. From Fisk again—

Ever since the Bretton Woods agreements – the accords after the Second World War which bequeathed the architecture for the modern international financial system – America’s trading partners have been left to cope with the impact of Washington’s control and, in more recent years, the hegemony of the dollar as the dominant global reserve currency.

Things have changed a lot since 1944 when Bretton Woods went into effect. Some economists have called the recent, now unstable, arrangement Bretton Woods 2. This is from Brad Setser, who was cited above—

In late 2004, Nouriel Roubini and I wrote that “the tensions created [by the Bretton Woods 2 system] are large, large enough to crack the system in the next three to four years.” In a 2005 Wall Street Journal online debate with Michael Dooley I tried to hedge a bit, and gave the system six years…

The Bretton Woods 2 system — where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports — will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much…If Bretton Woods 2 ends in 2009 — if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down — it won’t have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for U.S. debt would dry up — pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy. The US and European banking system collapsed before the balance of financial terror collapsed. Dr. Brad DeLong writes:

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ‘Balance of Financial Terror’ between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

The end result of this crisis though could be rather similar: a sharp contraction in credit, a fall in US economic activity, a fall in U.S. imports and a fall in the amount of foreign financing the US needs. The U.S. government is (possibly) trying to offset the fall in private demand by borrowing more and spending more — but as of now there is realistic risk that the fall in private activity will trump the fiscal stimulus.

Consequently, this still strikes me a crisis of the Bretton Woods 2 system…

Recall that Brad Setser wrote this in October, 2008 before the fiscal & monetary madness of the last year played out. Setser notes that in the crisis he and Roubini had in mind, Treasury rates would rise to make the dollar more attractive. Instead, treasuries have fallen to historically low levels, and short-term rates are close to zero. (Here’s the current yield curve.)

Just as Setser feared, U.S. demand for (Asian) imports fell sharply in subsequent quarters (Figure 1). For the first time in 68 years, there has been a sharp contraction in credit (Figure 2). And of course U.S. GDP is down considerably from last October (Figure 3).

Figure 1 — The continuing U.S. current accounts (trade) deficit. Trade is off sharply since the financial meltdown of 2008:Q3. The graph is from Calculated Risk.

Figure 2 — Total loans and leases at U.S. commercial banks. Loans held (credit) has shown the first marked decrease since 1940. The graph is from the St. Louis Fed courtesy of John Mauldin.

Figure 3 — U.S. Gross National Product (GDP) since 2004. Data are from the Bureau of Economic Analysis (BEA)

The only thing missing from Setser and Roubini’s scenario for a collapse of the Bretton Woods 2 system is “a fall in the amount of foreign financing the U.S. needs” or worse still, a sharp contraction in foreign demand for U.S. debt. U.S. foreign financing requirements have increased, not decreased. The preconditions of a crisis have arrived (Figures 1-3). Can the total collapse of economic mutual assured destruction (Bretton Woods 2) be far behind?

The precarious “balance of terror” between Asia and America continues for now, but if foreign demand for U.S. dollars dries up, the dollar will not be worth the paper it’s printed on unless Treasury rates are raised sharply and quickly. Such a rise would put a severe crimp in future economic “growth” in the United States, which is not guaranteed as things stand now even with short-term rates near zero.

It seems that the United States has gone out of its way to piss off its foreign creditors, to wit—

1. Committed U.S. entitlements debt is estimated to be approximately 55,000,000,000,000 (trillion) over time (for Social Security, Medicare, Medicaid, etc.)
2. The Obama administration forecasts additional government deficits of 9,000,000,000,000 (trillion) over the next decade. Anticipated “growth” in the economy (i.e. larger federal tax receipts) will not cover this new bill.
3. The dollar is imploding—the Dollar Index stands at 76, down from its high of ~89 in March, 2009
4. Significant deflationary pressures in the next year or two will be countered with continued low interest rates, which discourages foreign investment in Treasuries.
5. The U.S. Central Bank (the “Fed”) has printed about 1,600,000,000,000 (trillion) brand new dollars over the last year.
6. The secular change in American consumption patterns means that the American market for Asian exports will likely never return to pre-2008 levels, or at least not for a very long time.
7. To take advantage of an ever weakening dollar, re-allocation of capital to create export-oriented industries in the U.S. (e.g. in alternative energy) will take a very long time, assuming such a re-allocation ever happens at all. The U.S. would be less of a basket case in this event, which would support future imports from China and elsewhere.

If you are still sanguine about the future of the dollar because you have faith that mutually assured destruction will continue, consider the long-term history of the purchasing power of the dollar (Figure 5).

Figure 5 — The long-term history of the purchasing power of the dollar from Zero Hedge’s “Tyler Durden”

The future of the dollar is very shaky indeed, and if history is any guide, the dollar has no where else to go but down from here on out. People talk about deflation pressures in the next year or so, and they are right to do so, but serious inflation, perhaps hyper-inflation, is the only possible outcome longer-term.

Can you think of any scenario—let your imagination run wild—in which the dollar’s value is going to rise vis-a-vis exchange rates with the Euro, the Yen, etc. 5 to 10 years from now?

Now that you have a proper context for evaluating the veracity of Fisk’s story, does it strike you as unlikely that secret talks are being held to move away from trading oil in dollars? I hope not! As Tech Ticker’s Henry Blodgett said, in agreement with me, “how can these meetings not be taking place?” This is just commonsense.

An Orderly or Disorderly Wind Down?

There is little doubt the dollar is going to depreciate further in current years. The crucial question is whether this depreciation will be sudden and catastrophic, or planned and orderly. The Bretton Woods 2 arrangement could fall apart quickly. Willem Buiter of the Financial Times calls this a sudden stop event—

The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ – the cessation of capital inflows to both the private and public sectors. There has been a partial sudden stop of financial flows, both domestic and external, to the banking sector and the rest of the private sector, but the external capital accounts are still functioning for the sovereigns and for the remaining creditworthy borrowers.  But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency. A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.

Buiter wrote this in February, 2009, before the ineffective $787 billion stimulus package was enacted and before the Fed had fully expanded its balance sheet. His fear was that continued fiscal irresponsibility might trigger a sudden stop. It hasn’t so far, but this ballgame is far from over.

In an early morning interview with CNBC, Jim Rickards, director of market intelligence for scientific consulting firm Omnis, laid out a scenario in which the government inflates its debt obligations away in an “orderly” way over the next 17 years.

Rickards— … it has to do with gold. What [Fed Governor Kevin Warsh] is doing is pre-empting the collapse of the dollar. If gold goes to $1500/ounce … it has to do with the fact that the dollar is imploding, and so Warsh is saying to the G-20 that we’re not going to let that happen. Now, he can’t come out and say that [because] if a Fed governor starts to talk about the collapse of the dollar, the dollar would start to collapse, so he’s doing it by indirection, but when says “asset prices” I assume he means gold, which is inversely related to the dollar…

CNBC— You said off camera [the Fed] should have raised interest rates 6 months ago?

Rickards— Sure, the dollar is the lynch pin of national security. How are we going to conduct a war… The Fed needs the dollar to go down by about half over the next 14 years. We have $60,000,000,000,000 (trillion) of liabilities, that’s TARP, baseline budgets, stimulus, Ginnie Mae, Fannie Mae, Freddie Mac, Medicare, student loans, FHA … you go through all these contingent liabilities, it comes to about $60 trillion. There’s no feasible combination of growth and taxes that can fund that liability … We need to pay half, we can pay $30 trillion, not $60 trillion, so 4% [annual] inflation for 17 years cuts the value of the dollar in half. That’s what the Fed does best. If you had a nickel and three pennies in your hand, you had eight cents, that’s the value of the dollar relative to 1913 when the Fed was created.

The idea of price stability is nonsense. What they do is inflate the dollar to … prop up the banks. They need to do that [inflate] but that’s a dynamically unstable process. They would love to do it gradually, and that’s the plan, but  if the market gets ahead of it, if the market sees this playing out, which they probably will, you could have a very rapid collapse of the dollar … and you would see that in gold [prices].

[My note: Look again at Figure 5. Kevin Warsh published an editorial in the Wall Street Journal while the G-20 was meeting in progress, and that article is what Rickards was responding to.]

[My note: Rickards’ remarks relate to Triffin’s Dilemma, which demonstrates the impossibility of any one country’s currency being the world’s reserve currency for any extended period of time.]

Rickards goes on to discuss the IMF’s Special Drawing Rights (SDR), which China has proposed as a replacement for the dollar as the world’s de facto reserve currency. China’s stance, and the oil meetings Fisk reports on, are meant to pressure the United States to move toward fiscal responsibility.

Rickards’ contends that it was Fed Governor Kevin Warsh’s intention to say, albeit indirectly, that the Fed will indeed move to defend the dollar to head off its collapse regardless of the economic consequences. Unfortunately for we poor souls in the United States, any such move to defend the dollar will destroy any economic “recovery” we might have.

Rickards also says the Fed wants to move from the dollar to the SDR as the world’s reserve currency in a gradual, controlled fashion. It is not clear whether this will be possible because when the markets figure out what’s up, they will move away from the dollar into gold, a move which would further propel the dollar’s collapse.

Many believe the twilight of the dollar has arrived. This is not some lunatic conspiracy theory. The Telegraph’s Ambrose Evans-Pritchard reported on one major bank’s view in HSBC bids farewell to dollar supremacy.

“The dollar looks awfully like [British] sterling after the First World War,” said David Bloom, the bank’s currency chief.

“The whole picture of risk-reward for emerging market currencies has changed. It is not so much that they have risen to our standards, it is that we have fallen to theirs. It used to be that sovereign risk was mainly an emerging market issue but the events of the last year have shown that this is no longer the case. Look at the UK – debt is racing up to 100pc of GDP,” he said.

Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia’s “mercantilist mindset” of recent decades is about to be broken by the specter of an inflation spiral.

Here’s one version of what may happen: As time goes on, it will become clearer to China, Japan and others that investing in the United States is a waste of time. Inflation will be eroding the value of their dollar reserves and American investments. Specifically, it will become more obvious to them that the American consumer is down for the count, meaning their once robust American export market won’t support their economic expansion. When this realization sets in, the already unstable past (and present) Bretton Woods 2 arrangement will likely break down. The demand for dollars will slow considerably, and there may even be a headlong flight from the dollar. This latter possibility is Buiter’s “sudden stop” event.

No one can no how all this will play out, but I find little room for optimism regarding the dollar’s longer term future.

Contact the author at dave.aspo@gmail.com